Refunds of State Credits Are Includible in Income

By James A. Beavers, J.D., LL.M., CPA, CGMA

Gross Income

The Tax Court held that refunds of three types of New York targeted economic development tax credits must be included in the taxpayers' income.

Background

The New York Economic Development Zones Act offers state tax incentives to attract new businesses and to encourage expansion of existing ones. Since 2000, the program doling out these incentives has been called the Empire Zones Program (EZ Program). The EZ Program provides incentives to stimulate private investment and business development and tries to create jobs in impoverished areas in New York state.

Only certified EZ businesses qualify for certain EZ tax credits. A certified EZ business that meets specific employment tests is called a Qualified Empire Zone Enterprise (QEZE). QEZEs are eligible for additional targeted tax credits. The various EZ credits require that the business remain within a designated area and meet certain annual requirements. Although eligibility for the credits depends on a business's meeting specific requirements, credits earned by passthrough entities are passed through to the owners of the entities, and individual owners can use the credits against their personal income tax liabilities.

David and Tami Maines are partners in Huron Real Estate Associates (Huron), an LLC, and shareholders in Endicott Interconnect Technologies Inc., an S corporation. Through these entities, in 2005–2007, the Maineses received three types of EZ Program credits, which were fully or partially refundable: the QEZE credit for real property taxes, the EZ investment credit, and the EZ wage credit.

The QEZE real property tax credit is determined by a formula starting with the amount of real property taxes a QEZE paid and depends on when the business first became a QEZE. The credit cannot exceed the amount of real property taxes paid. The EZ investment credit is 8% of the cost or other basis for federal income tax purposes of eligible tangible property in an Empire Zone and acquired or built while the area is designated as an Empire Zone. The EZ wage credit is a per employee credit for EZ businesses that hire new full-time employees in special targeted groups.

In each of the years 2005–2007, the Maineses had little or no New York state income tax liability before application of the refundable EZ program credits. Therefore, they received refunds of each type of credit in each year. On their federal tax returns, they did not include the refunds they received in income in the respective years. They argued that following the tax benefit rule, the refunds were not includible in income because under New York law the credits were labeled as overpayments of state income tax, and they had not taken a deduction for state income tax paid in the preceding year on their income tax return for any of the years. Thus, the credit refunds were analogous to a refund of an overpayment of state income taxes made by a taxpayer that had not itemized deductions and claimed a deduction for state income taxes paid in the year the taxes were paid.

The IRS disagreed, finding that what New York called the credits was immaterial for purposes of the tax treatment of the credit refunds. It ruled that the EZ Program credits were not overpayments of tax but were instead cash subsidies from the state to the Maineses' businesses and thus were a form of taxable income. The Maineses challenged the IRS's determination in Tax Court.

The Tax Court's Decision

The Tax Court held that the portions of all three types of the EZ Program credits that were refunded to the Maineses were includible in their taxable income. The court found that the state law label of the credits as overpayments of tax was not controlling for federal tax purposes and the substance of the credits would determine their federal tax treatment. Looking at the substance of each credit, it found that the EZ investment credit and the EZ wage credit were actually taxable direct subsidy payments to the Maineses. It determined that the third, the QEZE real property tax credit, while being a refund of past overpayments of real property tax, was includible in income under the tax benefit rule because Huron had deducted the payments of real property tax on which the credit was based.

As the Tax Court explained, under the tax benefit rule as it applies to state income tax refunds, for a taxpayer to be able to exclude a state income tax refund payment from income, the refund payment must be for an overpayment of tax for which the taxpayer did not take a federal tax deduction when it was paid in a preceding year. Although the credits were objectively not an overpayment of taxes previously paid, New York state law labeled them as overpayments of tax. The Maineses argued that this label for state tax law purposes was controlling for federal tax purposes, citing Supreme Court cases such as Drye, 528 U.S. 49 (1999), where the Court held that state law creates legal rights and interests, while federal law designates how those rights or interests will be taxed.

While the IRS did not challenge the cases cited by the Maineses, it contended that if it were true that a state's legal label for a state-created right was binding for federal purposes, a state could undermine federal tax law simply by including descriptive language in its statute. The Tax Court agreed with the IRS and, citing its own precedent and that of the Supreme Court, found that a state law label for a legal relationship or transaction is not necessarily controlling for federal tax purposes and that, in determining tax treatment of legal interests and relationships established by state law, federal tax law looks to their substance rather than their form. Thus, the court stated, "The Maineses have a legal interest in the giant credits that New York law entitles them to . . . But federal tax law has its own say in how to characterize those payments under the Code."

Moving to the substance of the credits, the court noted that, under New York law, to qualify for the EZ investment credit, a taxpayer must own a business that places qualified property in service in a designated Empire Zone. To qualify for the EZ wage credit, a taxpayer must own a business that has full-time targeted employees who receive qualified EZ wages. Therefore, the court concluded that neither credit was, in substance, a refund of previously paid state taxes deducted under federal law. Instead, they were transfers from New York to the taxpayer that were essentially taxable subsidies.

The Maineses also argued per the Tax Court's decision in Tempel, 136 T.C. 341 (2011), a case involving conservation easement credits, that the full amount of the credits, whether used to reduce a taxpayer's state tax liability or available to the taxpayer as a refund, was not income to a taxpayer. The court disagreed, explaining that in that case it had stated that credits were not an accession to wealth and they were not income where they were used to reduce a taxpayer's tax liability. According to the court, it did not find in Tempel that the refunded portion of credits was not income.

The Tax Court found the QEZE real property tax credit to be different from the other credits. Taxpayers receive a QEZE real property tax credit only if their business qualifies as a QEZE and pays eligible real property taxes, and, importantly, the amount of this credit cannot exceed the amount of those taxes actually paid. Thus, the refundable portion of this credit is in substance a refund of previously paid property taxes even if New York labels it a credit against state income taxes. Accordingly, under the tax benefit rule, taxpayers who receive a refund of the credit must include the refund in their income to the extent they received a benefit from a deduction taken for these taxes when they were paid. This is true, even if, as may be the case with taxpayers who are passthrough entity owners, the person who pays the tax is not the person who benefits from its payment.

In the Maineses' case, Huron paid property taxes in 2005–2007, and it deducted these taxes on its federal returns. Huron deducted property taxes from its gross receipts to arrive at its net real estate income. Huron then calculated the Maineses' distributive share of its net real estate income and reported it to them on their Schedule K-1. The Maineses reported this amount on their Form 1040, U.S. Individual Income Tax Return.

Because Huron had deducted its property tax to calculate its net real estate income, the amount of net real estate income passed through to the Maineses was smaller than it would have been had property tax not been deducted. This decreased amount of passthrough income led to a smaller taxable income reported by the Maineses on their individual return, and thus a smaller tax liability. This decreased tax liability was a benefit to the Maineses, so the Tax Court found that the tax benefit rule applied. As a result, any refundable portion of the Maineses' QEZE real property tax credit payments was includible in income to the extent that the Maineses benefited from the previous deductions for the property tax payments taken by Huron. (The Tax Court, citing this decision, reached the same conclusion in a case decided less than a week later involving the same QEZE credit (Elbaz, T.C. Memo. 2015-49).)

Reflections

As an alternative argument, the Maineses claimed that the credits were not includible in income because they were welfare. While the court noted that the IRS has long held that some payments from social-benefit programs that promote the general welfare are not includible in gross income, one of the requirements for payments to qualify as welfare is that the recipients of the payments must show that they received the payments based on need. The court, which in several places in the opinion indicated its disapproval of the bounty of credits that EZ program participants could receive, stated that while critics of programs such as the EZ program have called them "corporate welfare," the EZ program credits were not based on need and did not qualify for the general welfare exception.

Maines, 144 T.C. No. 8 (2015)

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